When you ask the price of a trading pair in the forex market, you will definitely be given two different prices. But why? The reason has to do with the fact that one of those prices is the bid price and the other is an ask price.
And then we have the spread, which is basically the difference between these two prices. The spread in forex trading plays an important role. It is how traders can make benefits and it is also how forex brokers make their money.
In this article we want to see what spread can bring for you in forex trading and also what spread can bring for forex brokers.
Forex Trading: Obtaining Profits from Spreads
There are different ways in which forex traders can obtain profits. It basically goes back to the different methods and styles of trading. But as we just said, there is a baseline as to how forex traders can make money.
And that baseline method has to do with price spreads in forex. So let’s see how it actually works.
As we said the spread is the difference that exists between the bid and ask price of the trading pair. But what does it actually mean?
To understand these concepts better, we need to consider an actual forex trading pair. We are going to go with Euro denominated by the Swiss Franc – which would be shown as EUR/CHF.
The price that is quoted for the EUR/CHF as of now is roughly around 0.9599 which means that in order to purchase one unit of the base currency (in this case Euro), you need to pay 0.9599 of the quoted currency (in this case Swiss Franc).
So if you purchase this pair at this quoted price and then the price of the pair changes 20 pips, you will make a profit from the spread.
EUR/CHF = 0.9599 + 20 pips = 0.9619
The spread between your initial entry price and the new price is the spread that you can pocket as the profit from trading the pair. In this case it is equal to 0.0020 (in other words 20 pips).
So it is kind of similar to every single other market where you are hoping to buy low and sell high, or sell high and buy low.
With that concept in mind, this is exactly where we get to long and short positions and their relationship to the spread in the forex market.
Forex Spread in Long Position
How can the forex spread help you make money in a long position?
The long position is normally equated to a buy position. Naturally, in the long position you are betting in favor of the price of the asset or financial instrument.
So going long on a forex trading pair means buying the base currency in exchange for the quoted currency.
Going off based on the same trading pair we mentioned earlier, EUR/CHF, we can propose the following scenario.
You go long (purchase) EUR/CHF at 0.9599. This would equate to buying low in any other market. Because the only situation in which you will profit from your long position is if the price actually appreciates.
After all, the whole premise behind your position was the anticipation that the price would increase. So if they do, you will profit from your long position.
As we mentioned in the previous section, if the price of this pair experiences any increase, the difference between that price and the initial price that you paid for will constitute the profit for your position.
Forex Spread in Short Position
Now let’s see how a short position can be profitable based on the spread.
First of all we need to know what a short position is. A short position, which is mostly related to selling, is when the trader is pessimistic about the future of the market, or a single asset or instrument.
Of course, if you as the trader are pessimistic about the future of an asset, you wouldn’t put your money in it. This means you would bet against that asset.
So what happens if you bet against a forex trading pair or if you go short with the pair?
Since shorting is equal to selling, we’ll consider it that way. Selling a currency pair would be equal to selling the base currency and receiving the quoted currency instead.
Using the same pair as the example, when we short EUR/CHF it means we are willing to sell Euro and receive Swiss Franc instead of it.
Let’s use the same quoted price for the pair and go down (remember, we are in a short position).
If the quoted price goes from 0.9599 to 0.9579, it means the quoted price has gone down 20 pips.
What does it mean for you as the trader who has shorted this pair?
At first, for every unit of the base currency you had to pay 0.9599 Swiss Francs. But now for every unit you only have to pay 0.9579.
But you are in a short position, so the value of your position has not gone down. You still have the same amount as the beginning. Only the value of the base currency has gone down. This means based on the price spread, you have benefit the following amount (in Euros):
At the beginning of the short position you had 1 Euro (0.9599 CHF)
After the short position now you have 1.0020 Euro (0.9579 CHF)
So as you can see, in this situation because of your short position on the pair you have actually profited based on the final spread.
How Do Forex Brokers Make Money?
Forex brokers are the facilitator of the access that traders have to the foreign exchange market. Acting as intermediaries, they naturally need to make money to compensate for their efforts and services.
The way they make their compensation can be quite wide ranging. For instance, some brokers charge traders for deposits that they make into their account with the broker. On the other hand, some brokers also take a fee for withdrawals from traders’ accounts.
But you would be surprised to see just how many brokers actually do not charge traders any fees or commissions for the trades themselves.
Isn’t that surprising? Well, not really. Brokers make their money from somewhere else.
The Importance of Spread for Forex Brokers
As it was just mentioned, many brokers do not even charge traders for the trade or the transaction that is made in the market. The way that they actually make money is also through spread. But how?
The idea is actually pretty simple. The price that they quote for you, either bid or ask price it doesn’t matter, is usually a bit higher than the actual price of the currency pair in the market.
That difference between the price that pair has in the market and the price that the broker will offer you is the spread through which the broker will make most of their money.
The idea of spread plays a very important role in the foreign exchange market. It is important for both the trader and even the forex broker. Spread on its own is the difference between two prices. In the case of the trader, it is the difference between the bid and ask price. And for the forex broker, spread is the difference between the price quoted by the market to the broker and the price the broker will quote to the end user traders.